Bills Digest No. 117  1998-99 Taxation Laws Amendment (Software Depreciation) Bill 1999


Numerical Index | Alphabetical Index

WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

CONTENTS

Passage History
Purpose
Background
Main Provisions
Concluding Comments
Endnotes
Contact Officer and Copyright Details

Passage History

Purpose

The purpose of the Taxation Laws Amendment (Software Depreciation) Bill 1999 (the Bill), is to:

  • Modify depreciation provisions to allow a deduction over 2.5 years at 40 per cent, for expenditure incurred in acquiring, developing or commissioning software
  • Provide an option to create a pool for expenditure on the development or commissioning of software
  • Allow an immediate deduction for expenditure incurred, before 1 January 2000, on ensuring that an existing computer system attains Y2K compliance (including acquiring new software or substantially rebuilding current software) where the principal purpose is ensuring Y2K compliance, and
  • Provide transitional provisions to allow an immediate deduction for expenditure incurred until 30 June 1999 on software projects, which commenced before 10.00 am AEST on 11 May 1998.

 

Background

1. Deductions and depreciation

The tax base upon which tax is imposed is 'taxable income'. 'Taxable income' equals assessable income minus deductions.

Two types of deductions are allowed. First, a general deduction - which is any loss or outgoing to the extent that it is incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Second, a specific deduction - which is an amount deductible under specific legislative provisions.

In general, personal expenses and capital expenditure are not deductible. However, there are important exceptions including deductions for the depreciation of plant.

A deduction for depreciation is allowable on property which qualifies as plant used during the income year for the purpose of producing assessable income or which is installed ready for use for that purpose and held in reserve.

The primary factor in determining whether an item of property qualifies as plant is its function. If the function is to provide the setting or environment within which income producing activities are conducted (eg an office building), an item will not qualify as plant. Conversely if the function is essentially the permanent means or apparatus used to produce the income (eg machines) the item qualifies as plant, whether it is fixed or movable.

2. Position for deductibility of software prior to 11 May 1998, including the withdrawal of Taxation Ruling IT 26

Prior to 11 May 1998, software costs were generally deductible in the year incurred in accordance with former Taxation Ruling IT 26.

The costs of 'software' or 'programs' were accepted as revenue expenses deductible under section 51(1) of the Income Tax Assessment Act 1936. Where, however, the software was sold as an integral part of the computer system itself, for example, because of the technical nature of the computer system, the total computer system would be subject to depreciation and the investment allowance.

Taxation Ruling IT 26 was withdrawn at 10.00 am AEST on 11 May 1998 because the Commissioner of Taxation concluded that it no longer reflected the correct application of existing law in relation to software. The proposed amendments will apply to software expenditure incurred after that time.

The Bill is based on the assumption that the cost of software is not allowable as an outright deduction under the general deduction provisions because the expenditure is of a capital nature.

3. Year 2000 problem

The Year 2000 (or Y2K) problem, also known as the 'Millennium Bug', is found in computers that use the older two-digit date code format.

In the early days of computing, a programming convention developed whereby the date function used a 2-digit-year (YY) format instead of a 4-digit-year (YYYY) format, (for example '99' for '1999'). The two-digit date code format assumes that the century is '19' and as a consequence from midnight in the year 2000, the '00' will be interpreted as 1900 rather than 2000.

It is possible that computing systems may malfunction or completely fail from midnight in the year 2000 because the Y2K problem restricts their ability to accurately process date-related information for the year 2000 and beyond.

 

Main Provisions

1. Software Depreciation

1.1 Introduction

Schedule 1 amends the Income Tax Assessment Act 1997 to include new Division 46 - Software, which has four new Subdivisions being, new Subdivision 46-A Definitions and scope of Division, new Subdivision 46-B Depreciation of software, new Subdivision
46-C
Deductions for certain expenditure on software and new Subdivision 46-D Software pools.

From 11 May 1998 software costs are to be subject to the depreciation provisions.

  • Expenditure incurred in acquiring, developing or commissioning software will be amortised(1) at 40 per cent per year on a prime cost basis(2), ie over 2.5 years.
  • Software purchases of $300 or less will continue to be eligible for an immediate deduction provided that the total cost of all purchases of identical software does not exceed $300 in any income year.
  • Expenditure on software which has not been used or installed ready for use and which will never be used will be eligible to be deducted.
  • A once only election may be made to pool expenditure on developing and commissioning software provided that the expenditure is not otherwise deductible under provisions relating to minor amounts or Year 2000 compliance. Deductions for expenditure in Year 1 are written off at 40 per cent in the following two years and 20 per cent in the fourth year.

1.2 Meaning of software

New section 46-5 defines software to include 'a right to use software'. Rights to use software may arise as a result of simple licence agreements or more complex sub-licence arrangements, which may be in place as a result of the outsourcing of an information technology function.

1.3 Depreciation of software

New Subdivision 46-B provides for the depreciation of software.

Depreciation will apply to units of software on which expenditure is incurred as if they were units of plant owned by the taxpayer.

Therefore, a licence to use software will be treated as a unit of plant for the purposes of the depreciation provisions.

Pursuant to new sections 46-30, 46-35, 46-40 and 46-45 'expenditure on software' will be amortised at 40 per cent per year on a prime cost basis, ie over 2.5 years.

'Expenditure on software' is a defined term in new section 46-10 and includes expenditure in acquiring, developing or having another person develop software. It may also include salary or wages paid to a person who is involved with the development of the software.

Pursuant to new section 46-15 the provisions do not apply to expenditure on software if the software is trading stock(3) or if a more favourable deduction is allowable for the expenditure under other provisions of the Act.

 

1.4 Deductions for software expenditure

New Subdivision 46-C allows deductions for certain expenditure on software.

Under new section 46-65 expenditure on software purchases of $300 or less will be eligible for an immediate deduction provided that the total cost of all purchases of identical, or substantially identical software does not exceed $300 in any income year.

Under new section 46-70 expenditure on software that has not been used or installed ready for use and which will never be used will be eligible to be deducted provided that the expenditure does not form part of a software pool (see below). The amount of the deduction will be the total expenditure on the software less any amount of consideration derived in relation to the software.

1.5 Software pools

Under new Subdivision 46-D a taxpayer may elect to pool expenditure on developing and commissioning software.

A software pool is created under new subsection 46-80(1) by recording in writing the first income year for which expenditure on software is to go into it. Once made, the choice cannot be revoked, although there is a limited exception to this for the transitional period. (New subsection 46-80(2)).

Pursuant to new subparagraph 46-85(d) the expenditure must not otherwise be deductible under new section 46-65 (relating to amounts under $300) or new section
46-75
(relating to Year 2000 compliance).

Deductions for expenditure in a particular year of income (Year 1) are written off at 40 per cent in Years 2 and 3 and 20 per cent in Year 4 in accordance with new section 46-90.

All expenditure incurred on software development that commenced in the income year when the choice is made will be pooled, including expenditure on projects that were completed, and projects which were abandoned during the income year.

1.6 Transitional rules

1.6.1 Immediate deduction for expenditure incurred before 10am on 11 May 1998

Transitional provisions in Item 22 allow an immediate deduction for expenditure on software incurred before 1 July 1999, if at or before 10.00am by legal time in the Australian Capital Territory on 11 May 1998 (the Relevant Time):

  • a contract to acquire the software had been entered into, or
  • development or commissioning of the software had commenced.

Thus expenditure can be deducted for the year in which it is incurred rather than having to write it off gradually under new Subdivisions 46-B or 46-D.

1.6.2 Backdating software pool to 11 May 1998

Special transitional arrangements in Item 23 provide that where a decision is made to pool expenditure under new section 46-80 for the first income year beginning after the Relevant Time, a taxpayer may elect that the choice be treated as applying to expenditure on software incurred after the Relevant Time but before the commencement of the first income year.

This effectively brings forward deductions for that particular expenditure by one year because the deductions for pooled expenditure on software under new section 46-90 depend on the income year in which expenditure was incurred and not when the choice to pool expenditure was made.

In addition, further transitional provisions in Item 24 enable a taxpayer to revoke a previous choice to create a software pool when lodging a return for the second income year beginning after 11 May 1998. If a revocation is made expenditure incurred before the second income year remains in the software pool.

2. Year 2000 Expenditure

2.1 Deductions

Under new section 46-75 expenditure on software incurred before 1 January 2000 can be deducted if the principal purpose of the expenditure is to ensure that an existing computer system attains Year 2000 compliance.

2.2 Deductions for expenditure on new software or substantially rebuilding current software only available if expenditure incurred before 1 January 2000

On 5 August 1998 the Commissioner of Taxation released draft Taxation Ruling
TR 98/D5, which discussed the treatment of expenditure to achieve Year 2000 compliance.

The ruling stated that expenditure incurred on acquiring new software or substantially rebuilding current software would not be immediately deductible being capital in nature.

However, the final ruling TR 98/13 Income tax: deductibility of Year 2000 (millennium bug) expenses was expanded to specifically acknowledge the Government's budget announcement that legislation would be introduced to ensure deductibility for expenditure on new software (including upgrades) or on substantially rebuilding current software.(4)

New section 46-75 is the legislative mechanism to ensure that expenditure on such software will be immediately deductible provided that it is incurred before 1 January 2000 and the taxpayer intended to use the software or have it installed ready for use for the purpose of producing assessable income when the expenditure was incurred. After this date Taxation Ruling TR 98/13 will reflect the Commissioner's view on the deductibility or otherwise of such expenditure.

3. Diagram explaining the operation of new Division 46

The Explanatory Memorandum to the Bill(5) provides a very useful overview of new Division 46 in diagrammatic form.

Concluding Comments

1. Certainty regarding Y2K position

Without Taxation Ruling IT 26, which was withdrawn on 11 May 1998, software costs fell into 'a tax black hole'.(6)

The Commissioner had advised the Treasurer that without a legislative response, the withdrawal of IT 26 would mean that systems and application software would generally not be subject to amortisation, or, at best, would be amortised over 25 years.(7)

The decision to allow relatively generous(8) write-offs for expenditure incurred to ensure that an existing computer system attains Year 2000 compliance should resolve any uncertainty in relation to the taxation treatment of expenditure and provide the incentive for business, in particular small business, to take action on the problem.(9)

2. New software regime is not a concession

The business community, while welcoming the taxation measures for expenditure associated with Year 2000 compliance have indicated that the general software amortisation provisions will have a longer term effect with greater revenue implications(10) than the immediate deductibility of Y2K expenditure.

It has also been noted(11) that the new amortisation system will entail keeping sufficient records to identify expenditure that is not immediately deductible, and seems likely to require apportionment of costs based on time spent by employees working on development of systems and other activities.(12)

Endnotes

  1. The term is used as a synonym for depreciation. Depreciation is the reduction in value of an asset through wear and tear. An allowance for the depreciation on a company's assets is always made before the calculation of profit on the grounds that the consumption of capital assets is one of those costs of earning the revenues of the business and is allowed as such, according to special rules, by the taxation authorities. Bannock, Baxter & Davis, The Penguin Dictionary of Economics, Fourth Edition, Penguin Books, p.109.

  2. There are two methods of calculating depreciation: the diminishing value (or reducing balance) method and the prime cost (or straight line) method. Under the prime cost method, a deduction equal to a percentage of the original cost of the plant is allowable in each income year over its effective life. This method assumes that plant depreciates uniformly throughout its effective life. Australian Master Tax Guide, CCH Australia Limited, 1999, p.851.
  3. 'Trading stock' includes anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of business (Income Tax Assessment Act 1997 section 70-10; corresponding to Income Tax Assessment Act 1936 section 6(1)). The definition is not exhaustive. Anything that is trading stock in the ordinary meaning of that phrase is also included.

    Computer software produced or developed for sale by a software manufacturer or developer, or acquired for sale by a distributor, in the course of business is trading stock. Software produced or developed for licence rather than for sale is trading stock where the developer or supplier carries on business of trading in software licences. (Taxation Ruling TR 93/12).
  4. TR 98/13, states that:

    ' 4. Apart from the 1998 Budget announcement concerning Y2K expenditure, the deductibility or otherwise of expenditure incurred in making computer software Y2K compliant is governed by section 8-1 (the general deduction provision) and not by section 25-10 (the specific deduction provision relating to repairs). The extent to which the expenditure is capital or of a capital nature, and specifically excluded from deductibility under section 8-1, depends on the type of work undertaken ...

    7. Subject to paragraph 8 below, expenditure incurred in respect to what is, in essence, the complete replacement of computer software (eg substantially rebuilding software or acquiring new software) to achieve Y2K compliance, and testing the replacement, is of a capital nature and is treated as an acquisition of new software. The written down value of the replaced software can be written off in the year it is replaced. Rewriting of source or assembler codes does not, by itself, constitute a replacement of computer software.

    8. However, under the Government's 1998 Federal Budget proposal, expenditure incurred in respect to complete replacement of computer software, and testing replacement, is immediately deductible if it has the predominant nature of ensuring Y2K compliance. The proposal only applies to such expenditure incurred after 10.00am (Eastern Standard Time) on 11 May 1998 and up to and including 31 December 1999.'

  5. Explanatory Memorandum, p.4.

  6. David Hastings, Deloitte Touche Tohmatsu, reported in the Australian Financial Review, Budget 98 A5, 13 May 1998.

  7. CCH Tax Week, Issue 19 - Special Budget Issue, p.268.
  8. International Rules:

    United States: Fixing developed or leased software is deductible but the cost of new software is not claimable and must be capitalised and depreciated.
    Britain: In-house or external projects to rectify software are deductible unless part of a major new project instituting other changes of a capital or strategic nature. Replacing old hardware with Y2K compliant systems must be capitalised and depreciated.
    New Zealand: Diagnosing, correcting or testing existing software is a capital improvement that extends software life and must be capitalised and depreciated.
    Singapore: Y2K costs are expected to be capital but eligible for 100 per cent write-offs.
    Buffini F, Tax relief uncertainty for bug-fixing by business, Australian Financial Review, 20 April 1998.

  9. The Australian Society of Certified Practicing Accountants Small Business Health Index in April 1998 indicated that 78 per cent of small business had not spent any money addressing the Year 2000 issue.
  10. Crowe D, Higher costs for software projects, The Australian Financial Review, 14 May 1998.
    'Whatever they've given us on the Y2K front they've more than taken away with this amortisation ruling', Duncan Baxter, partner for tax services at Deloitte Touche Tohmatsu.

    'This is a change which will affect business in all future years while the tax deductions now available for Year 2000 costs will only apply up to the year 2000', Roger Penman, spokesman for the Institute of Chartered Accountants.

  11. Price Waterhouse, 1998 Federal Budget Analysis, p.11
  12. The Explanatory Memorandum (at paragraph 20, page 10) suggests that where a project is undertaken in the same place as business-as-usual activities it may be extremely difficult to accurately apportion costs such as utilities or salaries of support staff not directly involved in the development process and therefore it will not be necessary to treat such costs 'as expenditure on software' for new Division 46 purposes.

    However, Taxation Ruling TR 98/13 refers to the obligation to 'apportion the expenditure on a reasonable basis'.

Contact Officer and Copyright Details

Lesely Lang
22 February 1999
Bills Digest Service
Information and Research Services

This paper has been prepared for general distribution to Senators and Members of the Australian Parliament. While great care is taken to ensure that the paper is accurate and balanced, the paper is written using information publicly available at the time of production. The views expressed are those of the author and should not be attributed to the Information and Research Services (IRS). Advice on legislation or legal policy issues contained in this paper is provided for use in parliamentary debate and for related parliamentary purposes. This paper is not professional legal opinion. Readers are reminded that the paper is not an official parliamentary or Australian government document.

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ISSN 1328-8091
© Commonwealth of Australia 1999

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Published by the Department of the Parliamentary Library, 1999.

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